What Japan’s Rebalancing Can Teach Us

After such a long entry last week I thought I would spare my readers and do something much briefer. A few days ago I read a good article (“Stuck on Neutral”) about Japan in the August 18 issue of the Economist. You can find the article on the Economist website if you are a premium subscriber, but if not, it has been partly reprinted elsewhere.

It may seem strange to be reading an August article in March, but in fact I often find myself a year or more behind in my reading. This may seem a little perverse, but it does let me see what the smartest people were thinking at the time while knowing what subsequently happened. Among other things this makes it clear how often informed consensus gets bogged down in the minutiae of everyday events while trying to understand the bigger picture.

In the case of this particular article, however, what triggered my interest is that it was about Japan’s post-1989 rebalancing, and among other things discusses why, in spite of every attempt, Japan has not been able supposedly to rebalance the economy and achieve any real growth during the two lost decades after 1990. Private consumption never took off to drive economic growth.

Many of these reasons for low consumption we have heard before, and no doubt will hear again, but I am not sure how meaningful they are. According to the article, the Japanese don’t take enough holidays, they are aging, exporters squirrel away profits to replace households as a source of savings, small companies are too inefficient, government supports big business, the Japanese don’t like to borrow, house prices are too high, and so on. Maybe these really are the causes of the failure for the surge in consumption, but many sound like variations on accounting identities, and as such they are as likely to be consequences as causes of low growth.

But what interested me is that in spite of the fact that Japan’s economy didn’t grow, and contrary to the article’s claim, some serious rebalancing actually did take place, at least as I understand it. Japanese gross national savings declined from around 35% of GDP in 1990 to around 23% last year. The household savings rate dropped too, from around 10% in the 1990s to around 2%. Neither declined in a straight line, but decline they undoubtedly did.

Household consumption, according to the article, nonetheless failed to grow meaningfully – in the past two decades it only grew by 1-2% annually – and this is much lower, presumably, than consumption growth in the 1980s.

But it was nonetheless higher than GDP growth, and that is exactly the point: consumption growth may have been low, but it exceeded GDP growth. Rebalancing in the context of Japan (and China) does not mean that consumption growth must surge. It just means that consumption must grow faster than the economy so as to become a bigger share of GDP and a bigger driver of total growth. Put another way, it means that the savings rate must decline. If this is what actually happened, then in fact Japan did partly rebalance.

But, mysteriously, in spite of the fact that Japan may have experienced real rebalancing and a real growth in the relative share of household consumption, the Japanese economy stagnated during the past two decades. If you had predicted in 1990 that Japanese household and national savings would have declined so sharply as a share of GDP, and that consumption would have risen, you probably also would have predicted that Japan, after a couple of tough years, would resume rapid growth (or at least growth more in line with other rich economies) as surging private consumption pulled Japanese growth forward and away from its over-reliance on net exports.

But you would have been wrong on two counts. First, Japan did not grow very quickly at all. It stagnated as consumption growth actually declined. Second, its reliance on net exports did not decline. The current account surplus remained high as a share of GDP.

Why didn’t Japan grow more quickly? One reason may be obvious from the very fact that the current account surplus did not decline. Although Japan certainly rebalanced by some measures, its current account surplus dropped from its peak of 4.2% of GDP in 1986 to 1.5% at its trough in 1996, only to turn around and surge, eventually to reach 4.8% in 2007, dropping to 3.1% in 2008 on the back of the collapse in international trade (and albeit on a much smaller economy as a share of global GDP than in 1990).

Since the current account surplus is another name for the excess of savings over investment, obviously this means that national investment declined as sharply as did national savings. The article helpfully provides us with the numbers for both in an accompanying graph, and this confirms that investment indeed dropped, from a peak of around 32-3% in 1990 to around 22% last year.

With investment such an important part of Japanese growth prior to the bursting of the bubble, the fact that it declined so dramatically seems to have had a huge impact on Japan’s subsequent lack of growth. So although in some important ways Japan “rebalanced”, for two decades it was nonetheless unable to grow even with a still-very-high and rising trade surplus, largely because investment declined sharply.

I am not an expert on Japan by any means, even though in the past two years I have been giving myself a crash course on recent Japanese economic history, but my Asian-development-model story suggests at least one explanation of what happened. After many years of excess investment driving growth, Japan’s rebalancing process, which occurred after corporate, bank and government debt levels prevented the investment party from continuing, locked the country into many years of slow growth because it had to grind through years of debt-fueled overinvestment.

In fact Japanese investment jumped in the last two years of the 1980s, after the 1987 stock market crash in the US should have spelled the end of rapid Japanese export-led growth, from an already-high 28% to nearly 33% three years later. In other words Tokyo seems to have responded to the collapse in the US by increasing its already-high level of investment to counteract the impact on the trade surplus. This is what happened in China too, after the 2007-08 banking crisis in the US. This jump in investment seems to have kept Japanese growth going solidly for another two years after the current account surplus began its steep nine-year decline.

But growth in investment wasn’t maintained. After 1990, when investment growth could no longer keep up, perhaps because Japanese corporate, banking and government debt levels were becoming a serious constraint, the Japanese economy began a long, slow, painful decline.

The government tried to continue subsidizing growth over the subsequent decades by keeping both wage growth and interest rates low, not to mention maintaining the undervalued currency, as we know. This unfortunately may have slowed the growth of both household income and household consumption, while maintaining the high trade surplus. This also may explain why the drop in household savings was partly matched by the rise in corporate savings – households continued seeing transfers of income to the corporate sector.

But ultimately in spite of maintaining some of the old trade-related policies that kept manufacturing growth so strong for so long, there was nothing Tokyo could do to combat the effects of the decline in investment. Had they allowed a more rapid rebalancing via higher wages, interest rates and the currency in the first two or three years, perhaps they would have had a tougher time early in the 1990s, and a lot more liquidations, but ultimately they might have pulled out of the slump a lot sooner because they would have transferred income to households more rapidly (although of course had they done this too aggressively, unemployment would have soared and consumption collapsed).

So where am I going with all this? I am not completely sure, and no doubt I am oversimplifying the Japanese story. Certainly I am not smart enough to figure out all the inner workings of Japan’s economy. Just trying to keep the accounting identities in line and, making sure that everything that is supposed to balance actually does balance, is tough enough.

But this macro approach might have some benefit in that it shows how the overall system can constrain the micro-developments that we all hope for. At the macro level, in other words, it doesn’t matter what individual policies we take to boost consumption if these polices don’t in the aggregate represent a real transfer of income to the household sector, as they did not in Japan. Rebalancing must occur, but as an accounting-identify matter it can occur both through good ways (a surge in consumption) and bad ways (a drop in growth).

In Japan it occurred the latter way. Without a serious attempt to redistribute income more rapidly back to households, Japan rebalanced, but not via a surge in consumption. Since it could not maintain investment levels, on which the economy was too dependent, and in fact increasingly dependent after 1987, it rebalanced via a sharp slowdown in growth. Either way achieves rebalancing – which only means that consumption has to grow as a share of GDP – but of course the former is much better than the latter.

Japan’s experience suggests one of the risks China faces. It is easy to talk about rebalancing as a solution to the underlying problem China faces, but as the Economist article points out, rebalancing can be “tricky,” and it does not lead automatically to growth – that depends to a significant extent on how quickly consumption grows, and can take many years before that happens.

Will China rebalance? Of course it will. It is not a question of if but rather of how. The same was true of Japan. No economy the size of China’s can be so heavily dependent on exports to absorb its excess production, especially once unemployment in the rich countries reaches significant levels. And no large economy can keep investment rates so high – and the allocation process so constrained by governance issues – for very long without running into the problem of capital misallocation. But there are many ways rebalancing can occur.

Chinese household consumption will undoubtedly rise as a share of Chinese GDP over the next decade or two, but the process nonetheless can be disappointing for growth. It depends on lots of other moving parts, most importantly perhaps the change in investment and the speed with which income is transferred to households. And the change in investment might depend on debt capacity constraints and the extent of earlier overinvestment.

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.